Just when I thought I might switch to a topic less focused on the markets or tax policy (like savings tips to build that nest egg so you can invest it), we got a big jolt to the markets last week. Ben Bernanke summarized his views on the future of quantitative easing, which the markets did not take well. The decline was large enough that it is worth spending time on how the markets reacted and how to cope with times like these. I have some interesting data and commentary on how stock and bond markets respond to rising rates that might just get you through this!
Topics in this Issue
- What Upset the Markets Last Week?
- How bad are Rising Rates for Bonds?
- Are Rising Rates Bad for Stocks?
- How to cope With Volatile Markets
- Define Your Cash Needs and Keep a “Cash Stash”
- Build Diversified Portfolios
- Consider Averaging into Investments
- Think About and Do Something Else!
What Upset the Markets Last Week?
In case anyone missed it, the markets got the jitters in response to Federal Reserve Chairman Ben Bernanke’s remarks that the Fed could slow its quantitative easing program. Over the last several years, it has used various means to pump money into the economy to lower rates and encourage economic growth. The fact that markets have known that the Fed can’t continue an easy money policy forever didn’t seem to reduce selling of both stocks and bonds. Other previous safe havens, like gold, also declined. Many overseas markets were thrashed as well. There really wasn’t much of a place to hide besides cash.
Barron’s pointed out that John Williams, head of the Fed’s San Francisco branch, had said something similar only a month ago, but markets had climbed instead. In both cases, investors knew the Fed wouldn’t keep easing at this pace forever. Perhaps this time it was the fact that it came straight from the chairman himself that made the difference.
Mr. Bernanke also said that the amount of tightening would be data-dependent (meaning based on readings of economic growth, inflation and unemployment, among other things). This doesn’t sound like a steady march upward in rates, especially considering that inflation is very moderate and employment still has some ways to go before it hits Fed targets. But the markets overlooked that, too, and what appeared to be indiscriminate selling happened both here and abroad.
Of course, the press is filled with plenty of commentary, both positive and negative on the future direction of markets. What to make of all the conflicting opinion? While history does not repeat itself, at times like these, I really like some good hard, data. If nothing else, it helps filter the noise from the press and put commentary in context.
How bad are Rising Rates for Bonds?
A fellow named Andy Martin published an article earlier this month called “Bursting the Bond Bubble Babble.” Andy Martin is president and co-founder with Craig Israelson, Ph.D. of 7Twelve Advisors, LLC. While I don’t fully embrace the firm’s overall approach to portfolio management, the professionals there have studied historical data very thoroughly, and I think their points on bond portfolios are well taken in today’s environment.
The short version of this article is that in rising-rate environments, total returns for bonds generally have not been negative, if history is any guide. As defensive moves, Andy recommends shortening maturities and diversifying the types of bonds in your portfolio as much as possible. (This should sound familiar if you read my April 2013 newsletter and/or are a client of mine.) Importantly, they recommend equal weighting of various bond strategies.
Some of the data he examines to reach this conclusion include the worst periods ever for bonds. Were there some negative returns? Yes, but they were modest and far short of the disaster that many prognosticators would have you believe. Many of those comments assume that investors only own 30-year Treasury bonds, which in fact are owned by relatively few investors.
Why should diversified bond portfolios hold up as well as they do? Andy theorizes that it is because as rates rise, demand for bonds increases. In other words, they respond to supply and demand just like stocks.
If you are interested in a copy of the article, please drop me a note at email@example.com. It is reassuring reading that it is possible to play defense with bonds.
Are Rising Rates Bad for Stocks?
Barron’s recently interviewed Vadim Zlotnikov, the chief market strategist for Bernstein Research on this topic. The answer: it depends on the context of the rate increase. But the bottom line is that there has been no direct historical relationship between rate increases and stock market direction.
Zlotnikov mentioned that in a study of US market returns and rates going back to 1871, they observed that rising rates do not necessarily lead to bear markets. In scenarios where real interest rates (meaning net of inflation) were below average and rose 130 basis point (1.3%) or less, the stock market return was an average 11.1%, and 4.7% in real terms (again net of inflation). So if inflation is more or less benign and rate increases are moderate, the market can rise.
But when rate increases were sharp and sudden, the market return was 5.6%, but -2.3% in real terms.
So stocks tend to shake off rate increases, unless they are sharp and unexpected, and/or accompanied by high inflation.Barron’s goes on to point out that anything is possible, but those conditions seem to have little in common with today’s environment.
These results confirm studies done years ago by Steve Leuthold, the now retired researcher who founded Leuthold Weeden Capital Management (full disclosure: I hold shares in the Leuthold Core Investment Fund). Steve started out as an institutional researcher who produced voluminous histogram charts of market history on everything you can conceive of. Those charts clearly showed the same relationship.
How to Cope with Volatile Markets
So once again, some of the longest term data we can find leads us again to basic investment and planning tenets. While I would never minimize market volatility or economic concerns (today’s issue is China’s monetary tightening), there are some things we can do to help ourselves ride out market fluctuations.
1. Define Your Cash Needs and Keep a “Cash Stash”
When developing financial and investment plans, I recommend that clients keep some level of cash reserves on hand. The amount may vary depending on your needs, upcoming plans, lifestyle and stage of life (working or retired). But having that reserve is important, as it means you can ride out tough markets without withdrawing money from your long-term portfolio if the unexpected happens. Think of it every time the market experiences volatility or you happen to be confronted with screaming headlines.
2. Build Diversified Portfolios
Diversification is essential. Based on the information we just reviewed, we learned that rate increases don’t have to be a total disaster for the bond portion of your portfolio, and the stock portion of your portfolio may actually rise. Not only do you want to have both asset classes in your portfolio, but within each segment, maximize your diversification to ride out tough markets. Other types of assets may add even more diversification to your portfolio.
3. Consider Averaging into Investments
If you are faced with putting cash to work during tumultuous markets, you may want to consider staging your investments. In other words, you can dollar cost average into your plan over time, instead of placing all your money at once and then feeling bad about any declines that happen.
If your portfolio stays invested over a sufficiently long time horizon, most of the benefit of this approach is psychological, rather than monetary. But if it eases your mind and makes you more comfortable executing your investment plan, then it is definitely worthwhile. Just make sure to give yourself a deadline so that you actually get your investments completed. Also buy a cross section of your entire portfolio, so that you are holding something diversified. If you try to cherry pick investments and get too cute with timing their purchases, you could end up with an undiversified portfolio which could be vulnerable because it is unbalanced.
4. Think about and do something else!
Once you have done what you can with portfolio design and implementation, assuming you have your cash stash and some sort of financial plan, then you have really done all you can. We can’t control the markets through worry, so then it is time to focus on something else.
I hope this has been helpful so that you, too can survive the emotional roller coaster of investing!